Moody's Investors Service placed the 'B2' insurance financial strength ratings of XL Capital Assurance (XLCA), XL Capital Assurance (U.K.)  and XL Financial Assurance (XLFA) under review with direction uncertain yesterday, according to Moody’s release, and also placed the ratings of Security Capital Assurance (SCA) and a related financing trust on review for possible downgrade.

The ratings action was prompted by the SCA and XL Capital agreement approved by the New York Insurance Department and the Bermuda Monetary Authority. It provides for the termination of certain reinsurance, guarantees and other agreements with XL and its affiliates in return for a payment from XL of $1.775 billion in cash and 8 million shares of XL class A ordinary shares.

SCA also reached an agreement with Merrill Lynch, also approved by the New York Insurance Department, for the termination of eight credit default swaps on ABS CDOs written by XLCA in return for a $500 million cash payment to Merrill. Before yesterday’s rating action, the rating outlook for SCA and its subsidiaries was negative.

In accordance with Moody’s current rating policy, following the June 20 lowering of XLCA and XLFA ratings to below the investment grade level, the agency withdrew ratings on XLCA and XLFA-wrapped securities for which there was no published underlying rating, and said that if the guarantors' ratings return to the investment grade range or if Moody’s publishes the associated underlying rating, it would reinstate previously withdrawn ratings on those wrapped instruments.

The direction uncertain review on the insurance financial strength ratings of XLCA and XLFA reflects the improvement to SCA’s capital position and upward pressure on the ratings that would occur following the successful completion of the transactions, and also the likelihood of downgrades if the transactions fail to be completed.  


The master agreement and Merrill agreement are expected to close in early August 2008, and are subject to the completion of an $2.5 billion capital raise by XL and other customary closing conditions. XL said yesterday it has priced offerings of its equity and equity units totaling $2.5 billion.


If the contemplated transactions are completed, Moody's will likely change the rating review from direction uncertain to a review for possible upgrade; however, the agency said the insurance financial strength ratings are likely to remain non-investment grade given the continued uncertainty of SCA's remaining mortgage-related exposures and currently impaired franchise.


If the two agreements do not close by Aug. 15, Moody’s said the SCA’s insurance financial strength ratings would be lowered due to their subordinated status relative to policyholder claims; hence, the possible downgrade review.


Upon the successful closing of the agreements, Moody's will likely confirm the current ratings on SCA's preferred securities with a negative outlook.


Moody’s said that SCA is expected to record significant reserve charges on its mortgage-related exposures during 2Q08, including both second-lien RMBS and ABS CDOs, resulting in both XLCA and XLFA reporting negative statutory capital at quarter-end. However, Moody’s said that if completed, the companies will have positive statutory capital and an improvement in their capital adequacy positions.


Additionally, SCA has announced it has commuted its outbound reinsurance with RAM Reinsurance Co. and a portion of inbound reinsurance with Financial Security Assurance. SCA has also earmarked $820 million for commuting, terminating, amending or restructuring existing agreements with certain CDS bank counterparties who have signed the master agreement.


Moody’s ratings review will focus on: the successful closing of the master agreement and the Merrill agreement; the subsequent risk-adjusted capital adequacy position of XLCA and XLFA; prospective dividend capacity of the operating companies and preferred share dividend policy going forward; and an assessment of SCA's franchise value and future business prospects.

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